Price Hikes Aren't on the Menu for Restaurant Chains

With commodity prices at levels not seen in years due in large part to the drought sweeping half the nation, casual dining restaurants — not their diners — will take it on the chin.

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The drought has ruined much of the crop this season, reducing the supply available for consumption and thus sending prices higher. Month-to-date, commodity futures prices for wheat have increased about 46 percent, corn is up 43 percent, soybeans climbed 26 percent, coffee rose 16 percent, and milk rose 15 percent.

Zane Tankel operates 35 Applebee's restaurants in the New York area and says he can't reflect price changes in an instant like a supermarket can. Menus at the DineEquity-owned chain are printed quarterly, but beyond that, Tankel says increasing menu prices even a nickel causes his diners to speak up, and potentially eat elsewhere. As a result, he's never raised prices more than 2 percent on an annual basis.

However, most large casual dining franchises have long-term contracts with food suppliers, often for the calendar year, so at least for now, the recent price surge isn't being felt, according to Lazard Capital Markets analyst Matt DiFrisco.

But, if prices remain elevated or even uncertain, renegotiation with food suppliers could be financially painful. If commodity prices stay at these levels when it is time to re-sign contracts for proteins like beef, chicken and seafood and for vegetables and fruit, restaurants may end up paying more over the course of the contract than commodity futures will later dictate.

DiFrisco points to thepoor salesthat resulted atChipolte's after it raised prices 4.5 percent. The selloff of the stock that followed was Chipolte's worst percentage slide ever.

The price increase at Chipolte was a bit higher than the norm. According to the National Restaurant Association, menu price inflation has ranged between 1 percent and 4 percent over the last decade.

But the point has been made. At the moment, the fear of losing patrons may prevent restaurants from increasing prices to offset their rising costs. That means higher commodity prices are a worry for investors in casual dining stocks like Darden , Brinker International as well as DineEquity and others.

Restaurants average a pretax profit of 3 percent to 5 percent of sales and have to continuously work to manage escalating input costs to ensure margins remain as close to intact as possible, says Hudson Riehle, senior vice president of research for the National Restaurant Association. That means menu price inflation is still less than grocery price inflation year-to-date, Riehle says.

The one exception is fine-dining restaurants. Tankel, who was a director at Morton's Steakhouse's for many years, says fine-dining restaurants can raise menu prices much easier than casual dining venues because those diners are considerably less price sensitive.